"Steve challenges you to not only think differently, but to approach the process of thinking in a different way, enhancing productivity and creativity."

It's About the Journey​​​​​​​​​​​​​​​​​​by Stephen Duneier

If you are frustrated by choppy markets and long for the days when directional bets worked, I have a simple solution for you. Not only is the approach I am about to share going to help you ease the pain, it will actually make you cheer for the very thing that has likely been causing you so much consternation. On top of that, it will reduce your p&l volatility, while improving returns. Yes, it will improve your returns relative to volatility, thereby improving the all important (where’s the sarcasm emoji?) Sharpe Ratio. ​Let’s begin with your directional view. You believe stock XYZ is going up. It’s currently trading at $5 which you believe to be the bottom of the range. The point at which risk/reward is optimal. Therefore, it is the level at which you want to have the largest position (100%). Your target is $10, but it’s difficult to say how long it will take to get there or what exactly needs to occur in order for the market to come around to your way of seeing things. On the other hand, there’s always the possibility that you are wrong, that it is you who is missing something. If the stock trades down to $4, a level that is below the support line of the current trend channel and below the lows of the period that you have defined as “similar” to this one, you will close it out at a loss. By similar, I mean you have identified the states (key factors driving the stock price) and a period(s) in which those states are similar to what you believe will be in place for the foreseeable future. During that period, the stock never traded down to $4. Therefore, if it does, it’s likely you have missed something and so will close out the position.

Scenario 1

On Day 1 in Scenario 1, you purchase XYZ risking 1% of your AuM, meaning if it were to go straight down to $4, you would lose 100 bps. Instead, it goes straight up to $10 (see chart). As planned, you take profit, thereby generating a 500 bps return on your investment (see table). This is the scenario you fully anticipate when putting on the trade. You are decisive, deliberate, disciplined and most of all, brilliant! The world makes sense.

Scenario 2

Now, just for the sake of comparison, let’s explore a scenario that is slightly different. The stock price ultimately winds up reaching the target over the same time horizon, only this time it takes a slightly different path. No problem, right? After all, you are the same decisive, deliberate, disciplined and brilliant investor, so in spite of the volatility and the fact that it spiked up to $9 and back down below your entry level, you stick to your plan. As a result, you generate a 500 bps return and a sharpe ratio of 0.87 (see table).

There is one thing worth noting. Something that we’ve skipped over and which you likely didn’t take issue with in either Scenario 1 or 2, because this analysis is being done with the benefit of hindsight. When the stock was trading at $9, you were risking 500 bps in this trade. That is 5 times more than you were originally willing to risk. (In Scenario 1, when it was trading at $9.50, you were risking 5.5% of your AuM.)

I know what you’re probably thinking. “At that point I had 400 bps of profit, so I was really risking the same 100 bps.” However, that type of thinking is the result of improper framing, and it is a mistake that causes so many others on the follow. The reality for most traders is that at that moment, this trade is one of a dozen or more that are affecting the portfolio’s p&l. In that moment, you are well aware of the 500 bps of risk, because in your head you’ve already converted this “unrealized” p&l into “realized” p&l. Here’s the thing. That conversion is NOT a mistake. That money is yours. It’s not the bank’s. It’s not house money. It is yours. Unwind the position, and it’s now realized p&l. Reestablish the exact same position with the same take-profit and stop-loss, and you are risking 500 bps to make 100 bps. If your firm has drawdown limits, they too have converted this unrealized gain into a realized one, and it will affect your decision making. But it gets worse.

If you actually believe the trend channel is real, in that it reflects a discrete shift in odds at the support and resistance levels, and that the center of the channel possesses at least some gravitational pull from mean reversion, then the odds of a $1 move higher versus a $1 move lower are worse at $9 than they were at $5 (see Rational Approach to Momentum Trading for more details). That doesn’t mean the odds are skewed negatively or that the trade now has negative expectancy, necessarily. It simply means that the trade is less attractive than it was at $5, yet you’re risking 5x more now. ​You could say, “well at $9, I would just move my stop-loss up to the original entry level or maybe even higher.” Yes, you could and if you’ve been getting killed, or at least been underperforming your views for the past few years, it’s very likely that’s exactly what you’ve been doing. In this case, you would have converted a 500 bps profit into 0 bps profit accompanied by plenty of p&l volatility. Now let’s consider a different approach to the exact same trade.

Scenario 3

In this scenario, we will actively manage the risk at predetermined levels. To keep things simple so we can focus on the concept, we’ll use a linear management plan. As we’ve done in each of the previous scenarios, we’ll begin with a position of 1 million shares, thereby risking 100 bps at trade entry. For every $1 increase in the price of the stock, we will reduce the position by 1/5th or 200,000 shares. So, at $6, we’ll sell 200,000 shares, leaving 800,000 in the portfolio. At $7, we’ll sell another 200,000 shares, leaving 600,000 shares. It continues until we reach $10, at which point we’ll unwind our final 200,000 shares. However, that’s only half the management plan. In our example, after trading up to $9 in the first period, the stock dropped back down to $6. So here are the trades that would have been executed along the way.

Buy 1,000,000 at $5

Sell 200,000 at $6

Sell 200,000 at $7

Sell 200,000 at $8

Sell 200,000 at $9

Buy 200,000 at $8

Buy 200,000 at $7

Buy 200,000 at $6

If this management plan is followed from start to finish, you would wind up with a profit of 440 bps. Yes, that is 60 bps less than the 500 bps you would have generated had you simply purchased and held 1,000,000 shares from start to finish. However, your maximum risk over the life of the trade would be 300 bps rather than 500 bps. That means a max drawdown of 300 bps, not 500 bps, which means a lower probability that fear of drawdown will cause you to make a mistake. In addition, your sharpe ratio would be 1.22, rather than 0.87. That’s great, but what good is a higher sharpe ratio if you don’t take advantage of it? If the trade was worthy of 550 bps of risk in scenario 1, why isn’t it worthy of 500 bps of risk in scenario 3?

Scenario 4

In Scenario 4, we’re going to max out our risk at the same 550 bps seen in Scenario 1 by increasing Scenario 3’s size slightly more than 1.77 times. In this scenario, by the time XYZ reaches $10, I will have generated 781 bps in profit. Same stock, same stock view, same valuation, support and resistance, same max risk, but much better sharpe and significantly better returns.

Scenario 5

What if the stock doesn’t jump around like it did in Scenarios 2-4? What if it just goes straight up like it did in Scenario 1? Won’t I make less money? Well, if you start with the same 1,000,000 shares as you did in Scenario 1 and reduce your size by 1/5th along the way, the answer is, “Yes”. You will have delivered just 300 bps versus the 500 bps in Scenario 1. However, in that case you will have been undersized as it relates to your maximum risk, so it’s not a fair comparison. Either Scenario 1 is oversized or Scenario 5 is undersized. Let’s assume Scenario 1, which generated 550 bps of risk is matched in Scenario 5. In that case, S5 would deliver 531 bps of profit. Not as good as if spot had been bouncing around, like it was in S4, but still better than the old way of doing things, from both a return and risk/reward perspective. PLUS, it reduces the probability that you will hit the panic switch at an inopportune time, thereby avoiding the conversion of a winning view into a losing trade.

Optimization

It's worth noting that the trade management plan above has not been optimized. I’ve simply made a marginal adjustment to the traditional approach, and in so doing, have had a radical impact on the end results. Do that a few thousand times over the next few years and odds are, you will experience far better returns and far fewer stressful moments.

It’s also worth noting, I haven’t offered any “actionable intelligence” in the traditional sense. No trade idea, no interpretation of data or translation of Fed speak. That means your view, asset class, instrument and structuring are exactly the same. The only thing we’ve changed here is how you size and manage that sizing. Turns out, there’s more to generating alpha than just analyzing data and forming views.​Had we done some optimizing, say to maintain the same maximum risk across the board and thereby heavily skewing the sizing toward the early days, rather than after the “momentum” has built up, the returns would be better in both cases.

In the more volatile situation, the return would be 10.98%. That’s more than twice the return on the same view, same asset, same instrument, same valuation, same support and resistance levels. The only difference from the “disciplined” trade plan, is that the manager made more efficient use of their capital.

"While everyone else is scrambling to answer who, what, where and when, Duneier is focused on explaining the 'why'."

About the Author

For nearly thirty years, Stephen Duneier has applied cognitive science to investment and business management. The result has been the turnaround of numerous institutional trading businesses, career best returns for experienced portfolio managers who have adopted his methods, the development of a $1.25 billion dollar hedge fund and 20.3% average annualized returns as a global macro portfolio manager.

Mr. Duneier teaches graduate courses on Decision﻿ Analysis and Behavioral Investing in the College of Engineering at the University of California. His book, AlphaBrain, is due to be published in early 2017 (Wiley & Sons).

Through Bija Advisors' coaching, workshops and publications, he helps the world's most successful and experienced investment managers improve performance by applying proven, proprietary decision-making methods to their own processes.

Stephen Duneier was formerly Global Head of Currency Option Trading at Bank of America, Managing Director in charge of Emerging Markets at AIG International and founding partner of award winning hedge funds, Grant Capital Partners and Bija Capital Management.​As a speaker, Stephen has delivered informative and inspirational talks to audiences around the world for more than 20 years on topics including global macro economic themes, how cognitive science can improve performance and the keys to living a more deliberate life. Each is delivered via highly entertaining stories that inevitably lead to further conversation, and ultimately, better results.

His artwork has been featured in international publications and on television programs around the world, is represented by the renowned gallery, Sullivan Goss and earned him more than 60,000 followers across social media. As Commissioner of the League of Professional Educators, Duneier is using cognitive science to alter the landscape of American K-12 education. He received his master's degree in finance and economics from New York University's Stern School of Business.

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